Owners Should Never Gamble With Liquidated Damage Clauses
By: Adam Bailey and Dov Treiman
January 14, 2015
Real estate leases are, by their nature, bets the parties are placing on what the future may hold.
Both landlord interests and tenant interests try to hedge their bets by inserting clauses to produce certain results in the event of an uncertain future.
Chief amongst these mechanisms are liquidated damages clauses that seek to give to an event of breach of the contract at an unpredictable time with unpredictable consequences, certain quantification.
The importance of liquidated damages clauses are two-fold: They make the tenant think twice before breaching the lease or overstaying it, thus reducing the traffic in landlord-tenant court; and they allow the landlord an award of its full damages as it envisions them at the time of the writing of the lease.
Any attorney drafting contracts on a regular basis knows two different client goals for liquidated damages clauses.
First, the client may genuinely not know how to compute its damages in the event of breach and wants the contract to create compensation for such an event.
While some other areas of the law allow for arbitrarily assigning dollar figures to unquantifiable events, automobile accidents, for example, liquidated damages doctrine insists that there be some nexus between the agreed upon damages and the foreseeable loss.
If the landlord writes at that time what it reasonably believes the damages will be, the court will not judge the lease by later events, but rather by how the landlord originally explained its understanding of the future damages.
Second, the client may want the consequences of breach so draconian as to be unthinkable to the breacher, giving the protected party security that the breach will never occur.
As to this latter common goal, the law refuses to provide a mechanism. Penalty clauses are unenforceable and it is the foolish attorney who uses the word “penalty” in drafting a contract — except in the phrase “not a penalty.”
The contract’s language will not control the courts. Although the parties assert that the consequences are “not a penalty,” the courts will look to their severity and determine “whether a provision in an agreement is an enforceable liquidation of damages or an unenforceable penalty (as) a question of law, giving due consideration to the nature of the contract and the circumstances.”
The burden is on the party seeking to avoid liquidated damages to show that they are really a penalty, but doubts will be resolved in finding it to be penalty.
Although not required for enforceability that a liquidated damages clause explain in its own language what it is that makes the damages so difficult to calculate, it is required that the damages actually be difficult to calculate at the time the parties execute the lease.
However, the careful drafter should set forth an explanation of the difficulty in calculating the damages, not necessarily to define them, but at least recognizing them on sight, like the pornography in Jacobellis v. Ohio.
There are three salutary effects to having a clause that fulsomely sets forth the factors causing the difficulty.
First, it can convince the court that at the time of execution, it really was difficult.
Second, it brings the contract explicitly within the common law requirement that “There must be some attempt to proportion these damages to the actual loss. The parties must not lose sight of the principle of compensation.”
There is no clear statement in the law about just how proportionate the liquidated damages must be, but the standard appears to be that the clause is “reasonably proportionate” stated affirmatively or not “plainly disproportionate,” stated negatively.
Third, it forces the parties to confront the possibility that calculation is not difficult at all, and the drafters should instead of a liquidated damages clause, set forth a clause that gives the calculation’s methodology. Courts will enforce a liquidated damages clause if the damages are difficult to calculate at the time of signing the lease, even if they are easy to calculate once the breach actually takes place.
While largely focused on what happens if the tenant abandons the lease prior to its expiration, leases may call for liquidated damages in other events as well, such as, when the tenant fails to vacate at the end of the lease.
Although there are any number of breaches that can give rise either to a penalty clause or a liquidated damages clause, the two most common categories of tenant misconduct are: when the tenant leaves too early — when the tenant abandons the tenancy; and when the tenant stays too long — when the tenant holds over after the natural conclusion of the lease.
The case law uniformly tolerates best those clauses penalizing the tenant for staying too long and shows least indulgence for those clauses penalizing the tenant for leaving too soon.
New 24 W. 40th St. LLC v. XE Capital Mgmt., LLC, permits as liquidated damages a lease clause that accelerates the rent (making all the rent for the rest of the lease instantly collectible) but discounts it at the rate of 4 percent per annum. In other words, next year’s rent is recoverable at 96 percent of the full rent, succeeding years 92%, 88%, etc.
We do not believe four percent is the appropriate discount rate, but cannot predict what the minimum discount would be required before the acceleration of full rent would be considered a forbidden penalty.
Bates Adver. USA, Inc. v. 498 Seventh, LLC suggests the wisdom of specific liquidated damages clauses for specific breaches, but the reasoning behind the liquidation should be included for each predicted breach.
The law does not require a perfect prediction of the future, just a good faith explanation of what factors went into trying to account for it.
Real estate law has long recognized the value of stability in the law and stability in the contractual relations of the parties.
Review of every single reported liquidated damages clause of the past 100 years revealed their wide New York acceptance as they advance both these goals as well as the overarching goal to encourage people to abide by their contractual obligations.
Destabilizing them, particularly with regard to an extremely widespread practice in the industry, does little to advance well attested policies.